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To build on our high-yield strategy, but moderate the risks, we will need to examine which target industries and countries can help us attain our goals. Part 1 compared a dividend-growth baseline strategy to high-yield. Part 2 proposed that asset allocation and smaller-capitalization stocks can increase yield while moderating risk. In this article, we will look at global and industry opportunities to seek higher current yield-on-investment.

First, let’s not exclude the mega-cap, dividend-growth companies. The market may provide entry points for you to attain your yield objectives. With most investment advisors recommending that their clients invest in this segment, the wide appeal of the recognized brand names, and generally consistent results (in volatile times), it will be tough to find many high-yield opportunities in the mega-cap segment. Everyone is chasing these securities. To “seek alpha”, one will more likely need to invest in securities that the billion-dollar funds overlook, due to share float, credit-ratings, and other constraints.

There are many small mid-cap companies which pay generous dividends and are in the defensive industries identified in the table below. You may be required to look outside of the US and Canada for certain opportunities, but many can be found in North America.

One diversifies his/her holdings to mitigate risks. Choosing a strategy means selecting certain holdings instead of others. The following examples are limited to several sectors, and as you will notice, are generally necessities rather than discretionary products, and are assets that one can see and touch. This portfolio proposes limiting your USD exposure and buying higher-dividend-paying companies. The composition and geographic allocation of the proposed portfolio does have geographic, language, cultural, and economic-stage biases:

Sector/Examples

Geography

Yield %

Comment

Banks, Financial (BMO, CM)

Canada

5%

Solid balance sheets; utility-like regulation; an oligopoly - 5 banks represent almost the entire industry.

Telecom

(T, OTCPK:TLSYY)

US, Canada, Australia, UK

6% - 9%

Wires-in-the-ground plus mobile companies with histories of high dividends.

Utilities, Pipelines (AT, TRP, many US MLPs)

Canada, US, UK, Australia

6% - 9%

I suggest that people will always buy these services, at almost any price, to avoid freezing in the dark J.

REITs

(OTCPK:BOWFF, OTC:CRXIF, AGNC, NLY)

Canada , US

6% - 9%

Small and mid-cap equity REITs in Canada yield more than their US counterparts, and have had lower risk and better growth over the past few years. Mortgage REITs in the US provide very high yields, but are high-risk.

High and managed dividend-paying CEFs

USA

10%+

Asia, Europe, Gold/Mining, and Dow 30, CEFs. High-yields (with managed pay-out ratios) and one can efficiently play entire market segments and geographically diversify in USD.

Oil & Gas

(HUSKF.KP, LINE)

Canada, US

5% - 9%

Mid-cap, long-established, steady dividend-payers. Tend to be lower PEs than the large global names. Avoid geo-political risk by investing in companies with North American production.

Healthcare/Pharma

(PDLI, OTCPK:EXETF)

UK, US

Canada

6% - 10%

People everywhere get sick, and this can diversify currency. The US government healthcare cost-cutting may create entry points. I include Senior-oriented investment in this category.

Life Insurance

Property and Casualty Insurance

(Various Preferred shares)

Canada, US, Australia, UK

5% - 7%

Life Insurance: An inflation hedge.

Property and Casualty Insurance: A deflationary hedge. Both can be global growth plays, and global companies can provide a mechanism to invest in developing countries without a direct investment.

Agriculture

(TNH)

Canada, US, Australia

6%

Not generally performing to expectations, and generally not high yield, but one always needs to eat.

Other

Canada, US

7%

Opportunistic small positions in chemicals, mining, shipping, etc.

This proposes that you invest in the high-current-dividend (for a high yield on investment), rather than the dividend-growth end of the spectrum. The “Yield %” in the table is a typical range in these industries and countries. For example, CIBC (CM) and the Bank of Montreal (BMO) both currently yield over 5% (and are 2 of the 5 large banks in Canada). They have little exposure to European debt, and did not cut dividends during the last financial meltdown. For disclosure purposes, they represent most of my mega-cap exposure. Most of their preferred shares are trading at premiums, so look for common share buying opportunities on dips.

Many European Telecoms yield north of 7% (e.g., OTCQX:DTEGY, FTE, TEF), and Telstra (OTCPK:TLSYY); Australia, 9%. Of course, you need to adjust your portfolio holdings to your risk appetite (e.g., accepting lower-yielding Canadian banks) and local and personal taxation impact.

Look to invest in sectors which are strong in their geographies. For example, Canadians have a strong banking system and resource sector, but few consumer products companies. Europe and the USA may have excellent consumer products companies, but a lopsided risk/return profile in their financial sectors. Since you are taking risks on smaller companies, manage your risk by investing in industries and geographies which have a propensity for success. You may notice that there is not an overabundance of BRIC (Brazil, Russia, India, and China) country representation in the table. Other than one small, experimental position, I have no direct investments in these areas. Language (despite my family-name, I do not speak Russian), governance concerns, geopolitical risk, and the growth (rather than dividend-paying) nature of their securities, precludes them from my list. Depending upon your investment objectives and assumptions, you may find opportunities in these locales that I have not considered.

There are many reliable, well-known, non-domestic, small, mid, and large-cap companies traded on the various global stock markets. Many of these are available Over the Counter (OTC), which is an inexpensive way to access “name brand” foreign securities which may pay substantial dividends. The table, below, provides a few examples of some high-yield securities (none yield less than 7.5%):

Sample High-Yielding Securities*

Security Name (Ticker)

5-Yr % Return

5-Yr Div Grow

Div Yield

Mkt Cap

36 Mo Beta

52 Week High

52 Week Lo

Atlantic Power (AT)

32.21%

N/A

7.73%

$913M

0.13

16.34

12.91

Duet Group (OTCPK:DUETF)

11.7%

$1.9B

1.88

1.43

EON (OTCQX:EONGY)

9.43%

$45B

34.63

17.36

Extendicare REIT (OTCPK:EXETF)

11.68%

$583M

13.87

5.82

Linn Energy (LINE)

130.45%

121.74%

7.55%

$6.35B

0.7

41.13

31.03

Telstra (OTCPK:TLSYY)

8.83%

$40.5B

16.99

12.52

* Data is from www.barcharts.com on 2011-11-09; some OTC yields from CIBC Investors Edge. I could not find some data for OTC securities – this, and trading-volume issues can present a problem to investors (this may be the subject of a future article).

What we see is that you may need to concentrate on smaller market capitalization companies, with high yields, and mitigate risks by investing in low-risk industries. You may find some large-cap high-yielding securities, but the smaller capitalizations often provide the most generous yields, as you can see from Duet (an Australian utility) and Extendicare (a Canadian REIT, with 75% of its business in the USA) in the table above. Their 11.7% pre-tax yields far-outperform the other examples, which include high-yielding US and European securities. Atlantic Power (AT), with their recent share and debt issuance for the purchase of Capital Power Income L.P., presents a higher yield (and risk) for investors. On the other hand, their energy source is substantially natural gas, which is relatively green, has low cost prices, and is in abundant supply.

Archman Investor provided a supportive comment in Part 1 of this series of articles:

Invest in small & midcap higher yielding Canadian stocks that not only throw off higher than average yields but also do have the ability to exponentially expand their market caps in the future. They are relatively unknown in the US and hopefully will stay that way. They are not on Wall Street's radar and subject to little real manipulation.

There are certain high-yielding, large-cap opportunities – mainly in the European market – courtesy of the EU support for the PIIGS debt. The conclusion is that to find these prodigious-payers, you may need to consider securities outside of your national boundaries (through ADRs and/or OTC).

Your geographic diversification should also be made on an after-tax basis only. Some companies pay very high yields, but their tax jurisdictions – country of domicile – may have withholding tax rates of up to 35% (and certain securities and tax jurisdictions will not benefit from being in your local tax-sheltered accounts). I found that this website provides a useful listing of countries and their dividend tax-“bite”. Your country may have beneficial tax treaties in place, which will help manage the tax implications and improve your yield. The next time that someone publishes a list of high-yielding securities which include those in Switzerland or Chile, take a look at this table to determine if the return will meet your expectations (after their 35% withholding tax - although you may recover some of it at tax time).

There is one important consideration for all high-yield oriented investors. Certain industries are more sensitive to interest rate changes than others, and many of the high-yielding securities are in these industries. The classic example is mortgage REITs: mREITs earnings (and stock values) decline when squeezed by interest rates – the interest rate spread that they earn is compressed when interest rates rise. This is a two-edged sword. In the near term, your yield will be very high when compared to the near-zero market rates. However, if and when rates rise, the value of your underlying security is at risk. I am not sure if you are any more at risk than zero-yield and low-yield securities, but this risk is certainly worth stating. My belief is that if you treat your stock purchase like a 7-year bond that you are holding to maturity, then you will probably be at a break-even price at the next business cycle. In the interim, you will have enjoyed a far-above-average yield.

Let’s also be clear about a personal aspect of this strategy – it is not a low-effort endeavour. You will need to invest a lot of time and effort researching the securities and financials of companies. There are often differences in language, financial reporting standards, availability of information, accuracy of basic financial and market information, currency and credibility of analyst opinions, etc..

Moreover, potential investment targets may be domiciled on an exchange on the other side of the globe, with unfamiliar information sources. This reinforces the aspect of mainly investing through securities in first-world countries, but even with this constraint, there is no question that your effort to manage your portfolio will proportionately increase with the number of securities that you hold, or are considering to hold. It is a lot easier to invest in 10 mega-cap companies, such as PG, JNJ, and others, and then listen for Jim Cramer and other investment gurus to tell you when to buy and sell, but the latter approach will not provide the higher yield – the price of higher yield is greater effort.

One needs to be an active investor in order to manage for inflation and address dividend reinvestment for high-current-yield securities, when compared to dividend-growth securities; this is explained in a comment from ScottHB:

High-yield investing requires constant reinvestment to offset inflation - you build your own compounding. This means constant research, which is fine for me now as an active investor and the income stream I'm developing for retirement within the next 10 years is maximized. My plan has been to earn 15% more than I want for a generous retirement and continue to reinvest that 15% against inflation. However, looking 15 years out, I can see perhaps not wanting to be continually reinvesting. This is where I'm considering dividend growth to offset inflation - just harvest and spend dividends and have more dividends come in the following year.

Some of your effort will relate to the “buy low” requirement to improve your yield on investment. I never buy within 20% of the 52-week high, although this is certainly not aligned to a momentum strategy. I often wait for bad news to buy into a position. As long as the company has the cash-flow and appetite to maintain their dividend, and sufficient management talent to rectify the problem over the next few years, I want to enjoy the lower cost and higher yield.

In order to manage your average cost (and yield), you may choose to buy your positions in 2 – 5 separate transactions, depending upon the market price of the security. This does expose your portfolio to certain risks – for example, I have several positions which are only 25% of my desired holdings, but for which the price increased above my target (the implication is that the yield declined below my target). The opposite side is the infamous “catch a falling knife”, where one buys positions on the way down, and the security continues to decline as you expand your holdings. For these, I have a few 100% positions that I hope will eventually recover (but provide great yields in the interim).

The financial assessments are more difficult with smaller-cap companies, and events can be more impactful.

  • Payout ratios will typically be a lot higher than for the dividend-growth companies. Dividends are often funded through non-cash expenses, such as depreciation for fixed assets and property, or depletion allowances for natural resources. Try to avoid companies which pay dividends by taking out more debt.
  • Balance sheet, income statements, and cash-flows, have smaller numbers, so what are minor events for large companies cause major fluctuations for the smaller ones. For example, a flood which reduces oil production at one site will not have a material impact on Exxon (XOM), with its market cap of $373B and a yield of 2.4%, can impair the profits for Husky (OTCQB:HUSKF), with a $23B market cap and 4.9% yield, but can devastate the P&L for Zargon (OTCPK:ZARFF), with a $400M cap and 8.7% yield.
  • We all want to find companies with low forward PEs; fantastic ratios for debt, sales, and other metrics, including dividend yields of 10%. Unfortunately, if you see them, recognize that these are probably too good to be true. You will need to compromise (in other words, accept higher risks), in order to seek your return. Understand the numbers, compare them to their peer group, and decide if the incremental return is worth the marginal risk.
  • For small companies, one needs to be wary of major shareholders who are treating the company as their piggy-bank. On the other hand, it is good to have a major shareholder who is benevolent and acting on behalf of all investors. Try to look beyond the numbers to see if management is behaving in the investors’ interest.

We have described a strategy to increase your portfolio’s yield by:

  • Moving to high-yielding, smaller capitalization stocks.
  • Manage this risk through portfolio, industry, and geographic diversification.
  • Choose target industries and filter for high-dividend paying securities.
  • Consider the impact of withholding and other taxes on your return.
  • Invest in smaller increments to further dilute risk.
  • Become more informed about your target investments, their operating environment, and financials. This will likely demand more time and effort to select your investments.

In Part 4, we will specifically identify which industries, security types, and market segments will help us attain a very-high yield while mitigating some of the risks – in other words, what segments to buy. It seems that I will need to split-out those to sell (or not buy) into a Part 5, as the last two segments are becoming larger than anticipated.

Read Part I of this article »
Read Part II of this article »

Source: Positioning Your Equity Portfolio For High Yield With Moderate Risk, Part III